Thought of the Week
What does history tell us about rate cycles?
February 22, 2024 4 Minute Read
UK base rates have been on hold now at 5.25% for 6 months since August 2023, and the narrative has very much changed from “have we reached the peak?” to “when will rates come down and by how far?”. Our current forecasts suggest that the first reduction in base rates will happen in Q3 with a total 75 bp fall in 2024 and a further 100 bp over 2025.
On a historical basis this looks pessimistic. Looking back over the past 30 years or so, there have been nine periods where rates have peaked and remained flat for a protracted period prior to a rate cut cycle. On average rates stayed flat for 8 months but have been stable for as long as 13 months. More often than not, in the subsequent period base rates were cut sharply. On average base rates were cut by 240 bp in the year following the start of the rate cut cycle, but the cut has been as high as 450 basis points in 3 cycles. If the current base rate cycle was to follow the historical trend, it would suggest an imminent cut with rates of 2.85% in a years’ time.
While that seems dramatic, it's not out of the realms of possibility. Rates increased by 500 bp in less than two years, reaching a peak that hadn’t been seen for 15 years. So why shouldn’t they fall back in a similarly sharp fashion? Not least because as a nation we have become accustomed to the extraordinarily low levels of interest rate, and this is factored into our consumer spending, business investment and other financial decisions. The recent sharp increase will have a particularly acute effect on any interest rate related financial decision, and as a result the new equilibrium level will likely have fallen. So, while a 0.5% base rate - as was the average over the 2010s - is probably not the new normal rate, it’s unlikely to be as high the average over the 2000s of 4.3%, and certainly wont be as high as the 7.3% average over the 90s. It is more likely to sit somewhere in and around the threes.
Clearly the actual trajectory of rates depends on the underlying inflationary pressures in the economy, and while these are definitely subsiding, they have not abated, and we are likely to see a growth focused spring budget. If there are significant tax cuts, the Bank of England may want to wait to see whether any associated inflationary effects materialise. Still, when the Bank of England does start to lower rates, they may well come down fairly rapidly.
Historic interest rate cycles
Select the red pointers to see the length of peak and depth of subsequent rate cuts
Source: Office for National Statistics, Bank of England, December 2023
Using interest rate rises to curb inflation is a blunt tool, which takes time to play through. As a result, it is easy to increase rates too high or cut rates too low and then over tighten or over stimulate the economy. If the bank over tightens, the economy will slow more than expected, which will in turn lead to a subsequent sharp fall in rates. This leads to the distinct peaks and troughs in the rate cycle. If the interest rate mechanism was more direct and consistent a more gradual interest rate cycle would be likely.
